"The
ESM has financial resources amounting to €500 billion. Compare this with the
total government bonds outstanding of close to €2,000 billion in Italy and of about €800 billion in Spain and it is
immediately evident that the ESM will be unable to stem a crisis involving one
of these two countries, let alone the two countries together.

In
fact it is worse. As soon as the ESM starts intervening, it will quickly
destabilise the government bond markets in these two countries. The reason is
the following.

Suppose
a new movement of fear and panic, triggered for example by the deepening
recession in Spain,
pushes up the Spanish government bond rate again.

At
the end of the operation it will be clear for everybody that the ESM has seen
its resources decline from €500 billion to €300 billion. Less will be
left over to face new crises.

Investors will start forecasting
the moment when the ESM will run out of cash.

They
will then do what one expects from clever people.

They will sell bonds now rather
than later.

The
reason is not difficult to see. Anticipating the moment the ESM runs out of
cash forcing it to stop its intervention, they expect bond prices to crash. To
prevent making large losses, they will have an incentive to bring their bond
sales forward to the present rather than wait until the losses are incurred.
Thus the interventions by the ESM will trigger crises rather than avoid them.

This
feature is well-known from the literature on foreign exchange crises. The
classic Krugman model, for example, has the same features (Krugman 1969, see
also Obstfeld 1994). A central bank that pegs the exchange rate and has a
finite stock of international reserves to defend its currency against
speculative attacks faces the same problem. At some point, the stock of
reserves is depleted and the central bank has to stop defending the currency.
Speculators do not wait for that moment to happen. They set in motion their
speculative sales of the currency much before the moment of depletion,
triggering a self-fulfilling crisis.

Only the ECB can stabilise
bond markets

The
only way to stabilise the government bond markets is to involve the ECB, either
indirectly by giving a banking license to the ESM so that it can draw on the
resources of the ECB (see Gros and Mayer 2010), or by direct interventions by
the ECB. But the European leaders were unable (unwilling) to take that necessary
step to stabilise the Eurozone.

The
ECB is the only institution that can prevent panic in the sovereign bond
markets from pushing countries into a bad equilibrium, because as a
money-creating institution it has an infinite capacity to buy government bonds.
The fact that resources are infinite is key to be able to stabilise bond rates.
It is the only way to gain credibility in the market.

The SMP is the wrong
precedent

The
ECB did buy government bond markets last year in the framework of its
Securities Markets Programme (SMP). However it structured this programme in the
worst possible way. By announcing it would be limited in size and time, it
mimicked the fatal problem of an institution that has limited resources. No
wonder that strategy did not work.

The
only strategy that can work is the one that puts the fact that the ECB has
unlimited resources at the core of that strategy. Thus, the ECB should announce
a cap on the spreads of the Spanish and Italian government bonds, say of 300
basis points. Such an announcement is fully credible if the ECB is committed to
use all its firepower, which is infinite, to achieve this target.

If
the ECB achieves this credibility it creates an interesting investment
opportunity for investors. The latter obtain a premium on their Spanish and
Italian government bond holdings, while the ECB guarantees that there is a
floor below which the bond prices will not fall. (The floor price is the
counterpart of the interest rate cap). In addition, the 300 basis points acts
as a penalty rate for the Spanish and Italian governments giving them
incentives to reduce their debt levels.

The
ECB is unwilling to stabilise financial markets this way. Many arguments have
been given why the ECB should not be a lender of last resort in the government
bond markets. Many of them are phony (see De Grauwe 2011, Wyplosz 2011). Some
are serious like the moral hazard risk. The latter, however, should be taken
care of by separate institutions aimed at controlling excessive government
debts and deficits. These are in the process of being set up (European
Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and
sanctioning mechanism should then relieve the ECB of its fears of moral hazard
(a fear it did not have when it provided €1,000 billion to banks at a low
interest rate).

(...)

What should be done?

The
correct business model for the ECB is one that has it pursuing financial
stability as its primary objective (together with price stability), even if
that leads to losses. There is no limit to the size of the losses a central
bank can bear, except the one that is imposed by its commitment to maintain
price stability. In the present situation the ECB is far from this limit (Buiter
2008).

"Putting the ECB in
charge of banking supervision thus solves one problem. But it creates
another one. Can one still hold national authorities responsible for
saving banks which they no longer supervise?

This is not a new
problem. The De Larosiere Report (2009), which became the basis for the
creation of the European Banking Authority (EBA) and the Systemic Risk
Board (ESRB), argued that the ECB should not be involved in ‘micro’
supervision mainly because banking rescue and resolution involves tax
payer money, which they assumed had to be national.

First comes EZ bank regulation then comes EZ bank rescues

Banking regulation
and restitution are difficult to separate – no wants to pay for things
they cannot control. Economic (and political) logic thus requires that
the Eurozone will soon need also a common bank rescue fund.

Officially this is
not fully acknowledged yet, except for a hint in the EZ summit statement
of June 28/9 which says that once a system of supervision involving the
ECB has been created it would become possible for the permanent rescue
fund, the ESM, to inject capital into banks.

This is how
European integration often advances. An incomplete step in one area
later requires further integration in related areas. In the past this
method has worked well. The EU of today is a result of such a process.
But a financial crisis does not give policymakers the time they used to
have to explain things to their electorate. The steps will have to
follow each other much more quickly if the euro is to survive in its
current form.

Problems ahead

The worrying thing
is that the terrain EZ leaders must cross is heavily mined. Europe does
not have the luxury to construct its banking union from a stable
situation. This new institution is being set up in the midst of a
banking crisis.

There are clearly large losses that have to be realized and allocated.

This means serious distributional conflicts both within and between member countries.

The most difficult
case is going to be Spain. The local savings banks are the weakest part
of the Spanish banking system because they specialized in mortgages and
lending to developers, i.e. the areas where very large losses are to be
expected. A number of these were recently 'privatized', often in the
context of mergers. These new institutions then had to raise capital in
various forms (shares, preferred shares, subordinated debt).

Given that
institutional and especially international investors were not willing to
invest in these instruments (not surprising given that the state of the
Spanish real estate market) the new capital was raised mainly from
domestic investors, often the depositors themselves.

Who pays for past mistakes?

This leads to the first conflict: Who should bear the losses the (Spanish) investors or the Spanish government?

As retail investors
are also voters, the government (and the management of the cajas) have
now incentives to pay back as quickly as possible all instruments that
would otherwise be loss absorbing. This seems to be happening on a broad
scale. It is
thus possible that by the end of this year the weakest banks will have
repaid all of their hybrid instruments at par or close to par. At that
point the loss absorption capacity of the Spanish banking sector will be
much reduced.

But this leads to the second distributional conflict: Will the European tax payers want to pay for past losses? As
the answer is presumably no, there is thus a danger that by the end of
this year it will become impossible to inject European capital into
Spanish banks unless either a number of banks have gone into informal
insolvency (to bail in other creditors) or the Spanish government has
put enough into the system to cover past losses (which it might not be
able to do). The road towards banking union is going to be difficult."

" The European leaders this time have offered a more hopeful approach than
in the past in both form and substance, but Europe could still be
headed in the wrong direction unless the ECB builds an appropriate
bridge on the structure of the decisions taken at the June summit and
the political process implements those decisions comprehensively and
expeditiously."